Blue Chip Blues
Originally published on February 26, 2018
We all have that friend or relative whose investing advice is to park our money out in a couple shares of Coca-Cola or the Walt Disney Company. I mean, are they wrong? These companies have been around for decades, some even over a century—if they haven’t gone by now, they’re probably forever, right? Well, historically that hasn’t always been the case; recently General Electric, a long-time blue chip stock, has had its fall from grace. If you’re unfamiliar with investment lingo, a blue chip stock is simply a company that has widespread public recognition, is financially strong and usually withstands macroeconomic headwinds—like downturns and recessions—fairly well. The term “blue chip” comes from the game of poker; in the 1920s when the term was coined, blue chips usually represented $200, a significant value for the 1920s. Blue chips are usually considered to be a safe investment—with only US government bonds surpassing them in alleged safety. Most notable blue chip stocks comprise the Dow Jones Industrial Average (DJIA), you know the thing you hear about in newspaper headlines? (Side note: the Dow doesn’t really represent the US economy, but that’s a topic/ discussion for another time).
Based on their past performances, we like to assume that blue chip stocks are the safest investment we can park our money in—however, believing in this can be detrimental. Since the Dow’s inception over a hundred years ago, its component stocks have changed 51 times; in most instances, companies either merged or fell from grace. Most recently in September of 2017, Dow Chemicals merged with DuPont Chemicals to become DowDuPont Inc. and is now listed as a part of the DJIA.
If you’ve been following the news lately, you may have seen that General Electric (GE)’s share price has dropped by about 40 percent in the last year. So why has this blue chip of yesteryear suddenly experienced a precipitous drop in its share price in one of the Dow’s best performing years?
There’s actually not one singular reason (shocker) that GE’s in hot water right now. First, like your Uncle Carl who bought bitcoin at $19,000, GE made some bad investments in the recent years. In 2015, GE recognized oil and coal as the future of energy production and bought Alstom’s power business which produces coal turbines. They continued with that same mindset into 2016 when they merged their oil and gas business with Baker Hughes. Surprisingly for GE, yet unsurprisingly for anyone tracking energy trends and the price oil, these two investments proved to be nonstarters; there has been a steady increase in demand for solar and wind technology instead of coal and oil infrastructure, and this trend is expected to continue.
In addition to their bad buy-in to the oil and coal industry, GE’s books have kind of been a black box. No, GE’s accounting isn’t a thing on an airplane that records everything that happens. In the investment world, a black box basically represents a model where input is entered, and output comes out without us knowing how that output was computed. The same could be said about GE’s financials. In November, GE provided details about its contract assets; the company was counting revenue from long-term contracts before it had the cash in hand. This revenue, in some respects, isn’t real, but rather an estimation made by GE. This is just one of the many accounting issues that GE faces. In addition to a faulty investment and opaque accounting, GE’s financial arm—GE Capital—is running out of funds. GE took a $6.2 billion charge to help mend GE Capital and is setting aside $15 billion over the next seven years to build up its insurance reserves.
As a result of their accounting opacity, the Securities and Exchange Commission (SEC) recently launched an investigation into GE. Accounting fraud has led to companies like Enron in the early 2000s to fall. The presence of an investigation will not bode well for GE’s share price, and neither will it being potentially kicked out of the DJIA. If GE is kicked out the DJIA, investors with portfolios and indexes that track the DJIA will have to sell out of the position in GE, further driving down the price.
So what does the future look like for GE? It’s tough to say. GE’s CEO Jim Flannery commented that GE will begin to divest $20 billion in assets, and begin to focus on its core industries like aviation, power and healthcare. This tactic of specializing in specific niche fields is how companies like United Technologies Company (UTX) have become so successful in recent years.
There’s a couple different options on the table for GE. GE might begin to merge its subsidiaries, or sell their positions in them, in addition to potential downsizing. The company has confirmed that they will cut 12,000 jobs in their power unit—which currently employs about 57,000 people and is GE’s largest division. In total, GE has about 300,000 employees, so 12,000 represents less than 4 percent.
As the year progresses, it will be interesting to see how GE tackles this myriad of financial problems, the growing SEC investigation coupled with a possible removal from the DJIA. Either way, it’ll take some time to see if GE breaks its blue chip blues.
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